Employees Question Employer’s Tip Credit

May 1, 2019

For years, restaurants and bars and their employees often ignored tax responsibilities for tips, accepting the taxable income “under the table.” Compliance improved when the IRS instituted tougher tip reporting rules while also providing a tip credit to qualified employers. But it may not always be clear when employers are entitled to tip credits. Recently, a group of banquet hall employees brought the issue before an Ohio district court.

History of the Credit

A tip credit is available to restaurants and bars for employer-paid FICA tax on employee tips. By addressing the payroll tax that employers must pay, the credit is an attempt to eliminate the incentive to hide or underreport tip income. And, the IRS is more likely to get its fair share of taxable income.

Currently, the FICA tax is equal to 6.2% on the amount of wages up to the Social Security wage base ($132,900 in 2019) plus 1.45% on all wages. Both employers and employees must pay FICA tax. However, it can be difficult to determine and report wages in the restaurant industry, where compensation often is primarily in the form of cash tips. Workers who receive more than $20 in tips per month are required to report these tips to their employer. Then the employer must report this income to the IRS and withhold the requisite FICA tax.

Prior to 1987, restaurant employers were responsible for FICA tax on tips up to the minimum wage, while employees were taxed on all wages and tips. After 1987, the minimum wage ceiling for employers was removed, but the restaurant industry demanded concessions for this tax increase. The FICA tax credit was enacted in 1993.

Because Congressional budget rules make it difficult to reduce Social Security revenues, the credit was structured as it is today: Employers pay the full payroll tax on tips above the 1993 minimum wage ($5.15) and receive a dollar-for-dollar credit on their income taxes. When Congress raised the minimum wage in 2007, they left the benchmark at $5.15 for purposes of calculating the FICA credit. The credit isn’t refundable, so employers must owe some taxes to qualify for it. However, unused FICA credits may be carried back one year or carried forward up to 20 years.

Note that other issues relating to state income taxes may apply. Check with your payroll tax advisor.

Facts of the New Case

In Matusky v. Avalon Holdings, Inc. (N.D. Ohio, 3/29/19), employees of an Ohio banquet hall brought suit against their employer. Their duties included setting up banquet halls, serving meals, acting as bartenders, and cleaning up tables and the banquet room after an event. All the employees were paid below minimum wage. But the employer applied a tip credit, and the tips received by workers maintained their income above minimum wage.

Unlike in a restaurant, tips were issued to employees by the party host, not individual guests. The exception was the bartender, who might place a tip glass on the bar. The employees asserted that they didn’t receive tips for the time spent setting up before an event or cleaning up after an event. They argued that their employer shouldn’t have been able to take a tip credit because pre- and post-event work wasn’t tip-producing.

Under the prevailing regulations, an employer takes a tip credit for time spent on duties relating to the tipped work of an employee, even though those duties may not be specifically tip-producing. A two-part test is applied.

1. The Department of Labor (DOL) handbook places the burden on employees to prove that the duties are not tip-producing.

2. If this requirement is met, the employee must prove that more than 20% of the workweek is spent performing these non-tipped duties and that the employer took a tip credit for that time.

Court’s Ruling

However, the court ruled that the banquet hall properly took the tip credit. It found that the employees failed to establish that pre- and post-event duties aren’t tip-producing. The employees assumed that they spent more than 20% of their time performing non-tipped duties, but they didn’t provide evidence to support their position.

Employees contended that if a duty wasn’t tip-producing for a restaurant server or bartender, then it also wasn’t tip-producing for a banquet server or bartender. But, according to the court, this argument ignores the inherent differences between a restaurant and a banquet hall. It stated that banquet work requires a different kind of evaluation of tipped or non-tipped duties that may overlap. Finally, the court found that the workers’ claims failed as a matter of law because all of the duties they were required to perform were tip-producing in a banquet setting.

Are You Eligible?

Each case is decided on its own merits and different courts may rule differently. So you shouldn’t assume that the outcome of Matusky applies to your situation. If you’re unsure about whether your business is entitled to tip credits, contact your tax advisor.